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It's government, not markets, that ultimately shape the world economy. Remember the 1930s.

September 06, 1998|Ethan B. Kapstein | Ethan B. Kapstein, a professor at the Humphrey Institute of Public Affairs and in the department of political science, University of Minnesota, is author of "Governing the Global Economy: International Finance and the State."

MINNEAPOLIS — The world economy is in the throes of a nightmare. The emerging markets from Asia to Russia have tumbled like so many dominoes, and now they're taking the leading stock markets down with them. Investors have lost billions of dollars in this wholesale destruction of assets, with the worst--the collapse of Japan's banking system--possibly still to come. Everywhere you look, there's nothing but bad news.

The analogy that people have been grasping for in the midst of this turmoil is the debt crisis of the 1980s, when the governments of developing countries stopped paying their obligations to creditors in the United States and Western Europe. But that financial crisis was successfully managed by the immensely popular Reagan administration, which cajoled Congress into providing the international system with the liquidity it desperately needed until economic growth was restored. Today, such leadership is sorely lacking.

Sadly, a better analogy is provided by the experience of the early 1930s. The United States was led by President Herbert C. Hoover, a brilliant engineer who failed to understand the depth of the world crisis that followed from the October 1929 stock-market crash. Convinced that the U.S. economy was not only healthy, but would actually be strengthened by its biblical test with the financial gods, Hoover adopted a do-nothing platform that deepened and expanded the Great Depression. Rejected by the American people as unemployment spread, he was replaced by Franklin D. Roosevelt, who adopted the New Deal at home but was also slow to recognize the global role that the United States must play in leading the world out of its morass.

In Germany, meanwhile, the weak coalition government that presided over the post-World War I Weimar Republic found itself in an increasingly untenable economic situation. Squashed by the heavy reparations payments it had to make under the 1919 Versailles peace treaty, Germany found it impossible to earn the necessary foreign exchange through exports because of the Great Depression. The government saw no alternative but to crash the economy in order to save it, which it did in 1932. It drove the economy into such despair with its austerity package that the Allies had no choice but to renegotiate Germany's debts. The Weimar government won that gambit, but too late for a peaceful, democratic future. In 1933, Adolf Hitler won a plurality, as the Germans threw out the ruling coalition because of the suffering it had caused.

During the 1930s, the global economy turned to wreckage. States adopted beggar-thy-neighbor economic policies, devaluing currencies in a doomed effort to maximize exports and minimize imports, an impossible strategy when practiced by all. Rather than cooperate in the interest of overall growth, the great powers, including the United States, sought to isolate themselves in a desperate attempt to escape from the world's economic pain.

But these policies inevitably took an aggressive turn. Each of the world's major players formed self-sufficient economic blocs as the depression wore on, including the U.S.-led dollar bloc; the Japanese Co-Prosperity Sphere; the Zone Franc, which linked France and West Africa, and the British sterling bloc, which tied London and its colonies in a protectionist bond. Left out of this great game, Germany looked to Eastern Europe, expanding its influence in that region until it rubbed up against the Soviet border. Ultimately, the Great Depression came to an end on the battlefields of World War II.

The events of the 1930s remind us that the international economy ultimately rests on a political foundation, for good or ill. Despite all the talk about globalization and free markets, the world economy is nothing without governments and the paths they chart for their citizens. In the absence of a firm sense of economic direction provided by the great economic powers, especially the United States, investors must lose confidence in the future and, in the process, pull the plug of the financial markets.

This is what is happening today. Scanning a horizon that includes a Weimar Russia, a moribund Japan and a headless United States, investors are naturally seeking a safe haven. Withdrawing funds from emerging markets and stock funds, they are placing assets in banks and government obligations. None of these will help fuel future growth and, as growth prospects diminish, investors will become even more bearish. The world economy is on the verge of becoming trapped in this sort of vicious cycle, and it can only be broken by a massive liquidity injection.

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